LLC vs S-Corp: Which One Is More Beneficial For Your Business?

Eliot: Yes, I am, in our office on Rainbow.

Toby: I’m at a remote, undisclosed location. That’s in Miami, Florida. Anyway, you’re watching Tax Tuesday. Hopefully, this is your first time. We’re going to answer a whole bunch of tax questions. We’re going to go through what those questions are here in a second. It’ll be a lot of fun.

Eliot is in the control room. Actually, today, I’m probably going to be sitting in the co-chair and waiting for you to read all the questions. I don’t have to do it because I’m not really good at reading screens anyway. Why don’t you take it from here?

Eliot: All right, will do. First of all, a few rules we have here. You can ask your questions live via our Q&A feature in the Zoom. Please, if you have questions, specifically that are just general in nature, please put them into the Q&A. We have a whole staff there to try and answer those. A lot of CPAs, EAs standing by to take care of those.

You can email questions. Those are where we get the questions for Tax Tuesday. Email them to taxtuesday@andersonadvisors.com. That’s where we draw them from. We try to just take a few that we hope will hit the broad context of a lot of people and assist them.

If you need detailed responses, you need to become a platinum client or a tax client, where we can further address those types of issues. We try to make it fun and educational. We want to definitely give back that education to all of our clients and those out there. With that, we’ll look at what some of the opening questions are here.

“If I choose cost segregation, do I have to apply the cost seg to all properties purchased in the same year, previous years, and future years? What are the disadvantages—tax aspects and non-tax aspects—of doing a cost segregation?”

“I bought an apartment to fix it and put it up in Airbnb and to get the advantage of new business tax deductions. But now that we are thinking of renting it to regular tenants, this will be an investment instead of a business, correct? What are some of the deductions that we can take advantage of if we rent it to regular tenants instead of Airbnb such as renovations, expenses, travel expenses, furniture, and so on and so forth?” We’ll hit some of those.

“Is it beneficial to set up an LLC versus an S-corp? And are you able to pay yourself a reasonable salary through an LLC?”

“How should I hold my stock positions? What is the best way to deal with high capital gains consequences?”

“My husband will work as a real estate agent to qualify for the IRS’ definition of real estate professional, and potentially use the passive losses from our rental property to offset my W-2 income on our joint return. The IRS rule says my husband has to own at least 5% interest in the real estate company employing him. Does he need to form an S-corp to sign the contract with the brokerage firm so that he owns at least 5% interest?”

“I sold an investment property on October 21 and paid a very heavy capital gains tax. Can I get some of that back if I buy another investment property today or now?”

“How many years can we go back without showing a profit?” I think we’re getting into a hobby loss rule there. We’ll explore that.

“Is it okay to do your own taxes as a business owner if you had a CPA for 20 years?” Why is it a questionable call there?

“I bought a single family rental in November and am still repairing. No income yet. How do I record depreciation and costs for 2022?”

“How to save taxes by flipping and renting houses?”

“I just started my business in August of 2022. I would like to understand what from a tax perspective should be on the top of my mind as we prepare the first returns.”

Lastly, “If an investor purchases a property that is lower in value than the property sold in a 1031 exchange, will the IRS disqualify the exchange entirely?” Those are the questions that we’re going to get to today.

First of all, we look at Toby’s website here for Infinity Investing and the YouTube channel. A lot of good stuff there. I don’t know if you can see this Toby.

Toby: I can see it, and I think they should go and subscribe. It’s free.

Eliot: You got to hit that little subscribe at the top there.

Toby: For all the metalheads out there, I just did an interview with Joey DeMaio of Manowar. They’ve been rocking it out for over 40 years, and I think you should go watch that, too. It has nothing to do with tax, but it was cool that we got to interview Joey. He’s a really cool dude and one of the original heavy metal guys.

He used to do the headbangers ball on MTV. They would always tear their shirts off and enact like rockers, but he’s actually truly legit and an amazing musician. Anyway, go to the YouTube channel. Click on subscribe. It’s fun.

Eliot: There you go. We got to track how the record sells now after that little nudge there for it by you.

Toby: Somebody says, can you write-off guitars and coke? Like Coke Zero? Is that what you’re talking about?

Eliot: Meals and entertainment. Again, our YouTube channel here. Subscribe on YouTube for the latest updates with our ABA link. Subscribe there and get some free replays of a lot of the material we have out there. We got Clint putting a lot of videos out, Toby, a lot of our staff out there. I think we have Coffee With Carl on YouTube as well there, so a lot of good stuff there.

First question, “If I choose to do a cost segregation, do I have to apply a cost seg to all the properties I purchased in the same year, previous years, and future years?” We’ll just start right there. Do you want me to handle that one, Toby?

Toby: Of course.

Eliot: If you do a cost seg, you’re not required to use it on your other properties. That’s very specific to one property. They’re going to do the study on that one property. You’re not going to have to worry about the others. You certainly could do the others maybe to your benefit, maybe not to the others, and maybe use those in future years or something like that.

I’m reminding everyone that the bonus depreciation is going to go down over time, at least right now, so you do not. You’re not forced to use it on all of them. Even if you aggregate, you’re not responsible for doing that.

A little bit about for those who don’t know what a cost seg is, that is where we’re used to taking the 27½-year straight line depreciation off if it’s a family rental. The cost seg breaks that building up into pieces from a tax standpoint to 5-, 10-, 15-year, and some 27½-year property. What that does is just speed up the depreciation, it doesn’t add any. You still have the same dollar amount overall. Front-load some depreciation, which often can give some tax benefits. But no, you are not required to put it on the other properties.

Toby: Let me just interject real quick to make sure everybody understands what cost segregation is because it’s easier with a visualization. If you ever bought a rental property, let’s say it’s a condo, we won’t even make it a single family, a building, or anything like that. But you walk into it and you look around, you see carpeting that you just put in, maybe you put in some new cabinets and some appliances, things like that. Those items that you just saw, that carpet, for example, might be five-year property according to the IRS. The cabinets might be five-year. Appliances might be five, seven, or whatever.

They all have a useful life, and it’s not 27½ years. When you buy a property, your accountant instinctively will say, well, we can’t write-off the land, we can’t take a deduction for the land. What we can do is take a deduction for whatever you improved on that land. That’s where cost segregation comes in. Most accountants treat it if it’s residential, they’ll write it off over 27½ years.

Imagine you have a property that you bought for $350,000, maybe the land is worth $75,000. You’d take 350 minus 75, that would get you to $275,000. Using really simplistic math, and it doesn’t quite work this way, but you divide that by 27½, you’d get about $10,000 a year. That’s a deduction. If I bring in $20,000 a year in rent, I get to write-off $10,000 a year, so I’d only pay tax on $10,000 a year of that income.

What cost segregation does is it allows us to write things off much faster. If it’s that same property, $350,000, there’s land that we can’t depreciate, so we get down to $275,000, that’s the improvement value, you might get an $80,000 deduction in the first year. That’s because you take the carpet, the cabinets, any land improvements, any appliances and all those, and you write them all off in a single year.

In 2022, we could literally write-off anything that had a useful life of 20 years or less. We could write it all off in year one, 100%. In 2023, it’s now 80%. It went down just a little bit, but it’s still really potent.

Let’s use our example. Let’s say that we bought it in 2022. You can get an $80,000 deduction. We just went from having taxable income under that example of about 10,000 to having a passive loss of over $70,000. That’s what cost segregation does. It takes all this depreciation that would have been spread out over 27½ years, and it brings it all to the front.

Let’s say you could write it off. You don’t have to do that. Just like Eliot said, hey, I don’t have to do that to each property. The same is true as I don’t have to bonus depreciate, I can just write it off faster.

Hey, it’s a five-year property now, the carpet’s this much. These items that are removable, the shutters, and all these things are X. The appliances are this much and we’re writing them off over many years. The land improvements, maybe there was a parking lot put in, sidewalks, and a fence, I’m running those off over 15 years and I just spread them out over 15 years.

It might be that I don’t even have to do bonus depreciation. Technically, the permissible methodology is to break it into its components. They allow you to use what’s called an impermissible method of spreading it over 27½ years if it’s residential property, but that’s because it works to your disadvantage. The way that you’re supposed to do it is the way that works to your advantage, but requires the cost segregation study, that’s all.

You have a little bit of elbow grease. I got to have the engineers come out, take a look at it, and tell me what each piece is worth. But at the end of the day, it’s going to help you out if you have passive income. It’s going to either eliminate it or significantly reduce it. That’s why you hear about cost segs all the time. If you’re somebody who’s a real estate investor, cost segregations and bonus depreciation are your friend.

Eliot: Absolutely. I apologize, Toby. I don’t know if you hit this. But even if you do a cost seg, you got that 5-year we’ll call ban of property—10, 7, 15, whatever it is. You can actually just do the five-year property for the bonus. You don’t necessarily have to bonus to all the others, so that might be advantageous in your planning as well.

Toby: Maybe you just break out the pieces of it. You went from having a $10,000 a year deduction. In my example, I use the crude methodology of $275,000 of improvement and you divide that by 27½ years. Now you’re taking a big chunk of that and making it five-year.

Maybe the deduction, when you’re all said and done, is hey, maybe it’s $18,000 a year deduction, whatever it is. You’re like, hey, that’s cool. I’m not going to really have any income no matter what and I’m okay paying a little bit. Maybe that’s all you do. You don’t have to do the bonus.

Eliot: All right. Second part to that was, “What are the advantages, tax aspect and non tax aspects, for doing the cost segregation?” I would just say that, maybe a disadvantage, you have to pay for the study. We’re going to recommend you pay for the study. There’s someone who goes out there and does it on their own. I think that’s very much buyer beware, so you want to have a professional study done there to outlay that cost.

A lot of good people do it. We work with the Cost Seg Authority. They’re going to go out there and tell you exactly a good estimate of how much you’re going to save. You know what you’re going into whether or not it’s cost effective or not for you, so that problem can be solved.

Toby: Let me go over a couple of things because there are some questions here. It says, “Does cost seg need to be done the year the property was bought?” Nope. You can go back and you can do it. The bonus depreciation depends on the year you put the property into service. If I bought a property in 2019 and I do the cost seg this year, even though bonus depreciation in 2023 is 80%, in the year that I bought it in 2019, it was 100%, that’s the year we use.

Somebody said that they are using Cost Seg Authority and they’re mad about how they valued the land. It depends on whether you’re doing the actual study because usually, you’re using an appraisal or you’re using the assessed value. You can use the ratio of the assessed value to the improvement or you can actually get an appraisal where they break down the land.

Let’s just say that you have an assessed value on your land of $500,000, but your land is worth $800,000. The land value on the assessment is $100,000, so it’s 20%. Your land value would be 20% of whatever the price is that you paid for the property. If you bought it for $800,000, the land value is $160,000 (20% of $800,000). You’re allowed to do that, or you can go get an appraisal done.

No, you’re not stuck with it. You can always use it. What you really care about when you’re using somebody like Cost Seg Authority is they’re breaking out the value of the improvement. The 5-year, 7-year, or 15-year property is what they’re doing. It could be a ratio. Sometimes it’s a percentage of it. What I would do is I would contact them and say, hey, this is how I want to deal with it.

Somebody says, “In the example of the loss, do you lose it or do you just keep using it carry forward?” You carry forward. You can absolutely do it. Sorry, there were a bunch of little chat questions.

Eliot: Absolutely. Any disadvantages that you can think of other than the cost of the study?

Toby: You always calculate it. The disadvantage is that if you sell the property, in the first few years, you could have ordinary income recognition of the depreciation that you accelerated. It could be at your disadvantage depending on your tax situation in whether you get a big tax hit, versus if you just ordinarily depreciated it at 27½ years, you’d have less recapture, in theory. But it’s like all things, I say, calculate. Calculate, calculate, calculate.

Those are your three rules of tax, calculate, calculate, calculate. Again, it depends a lot and see whether it makes sense. We’ve done cost segs after a property is sold. If you sell a property in 2022 and you’re not happy with the tax situation, have somebody do a workup for you—Cost Seg Authority does it for free—and see whether it will save you money to get a cost seg done even after you sold it. It still works. You might find that you have less recapture or that the tax situation.

Let’s say that I’ve had a property for 10 years, I sell it, and I have to recapture tax on the carpeting. The carpet’s not worth anything. But under ordinary recapture rules, I have to recapture it all 25%. If I break it out into its components, I have zero recapture on something that’s beyond its useful life, so then that carpet would be zero recapture. It’s all treated as gain, and I might be at 15%. It just depends on my situation.

Eliot: All right. Next question. “I bought an apartment to fix it and put it into Airbnb and get the advantage of the new business tax deductions, but now we’re thinking of renting it to regular tenants long-term. This would be an investment instead of a business, correct? What are some deductions that we can take advantage of if we rent it to regular tenants instead of Airbnb, such as renovations, expenses, travel expenses, furniture, et cetera?”

Turning it into a long-term rental, you pretty much get some of the same deductions you would as a long-term versus short-term. They’re the same. You’re going to have cleaning expenses. You just might have more with a short-term rental than you do with a long-term. You’re still going to have depreciation, you’re still going to have property taxes, and things like that.

The furniture, typically, we’re going to see that in a short-term rental where you’re going to go out and buy the furniture, so you would have that in the short-term. If you wanted to have a furnished long-term, you certainly could do that there and deduct the furniture.

A lot of them are going to be the same expenses, even travel expenses if you had to go down there and meet with people who are going to assist you with this or something like that. I don’t see a whole lot of differences in the deductions. In that regard, the operational deductions (I’d say) you just might have more in some category via short-term or long-term, depending on which it is. I don’t know of any other special deductions for one or the other. Do you, Toby?

Toby: No. Here’s the thing, if you have an Airbnb, if it’s seven days or less average rental, it’s treated as a trade or business. The deductions become (in theory) non-passive, unless you don’t materially participate on your Airbnb, in which case, it’s business loss that’s passive. No different than rents. In a weird way, they could be identical.

In this situation, you’re looking at it saying, hey, I wanted to get an Airbnb so that we could get an ordinary loss. If we materially participate in it, then I could accelerate some depreciation. I could use that, in my previous example was the $70,000 loss. That could be used against your W-2 if it’s not passive activity. Airbnb, generally speaking, is not a passive activity so long as you materially participated in it.

I always say it’s a pizza business. If Eliot and I started a pizza shop, and Elliot flipped pizzas and did the pizza stuff, and I did nothing, I was outside the business, when it pays out its income, Eliot’s active income, active ordinary income subject to self-employment tax, or FICA, or Social Security, whatever you want to call it. Me, though, I didn’t participate so it’s passive. I can even use rental losses to offset that income. That’s how cool it is.

Airbnb is a pizza shop. Did you materially participate? If the answer’s no, then it’s trade or business, income or loss, but it’s still passive because I didn’t materially participate. But if I did materially participate, then if I have a business loss, it’s ordinary loss. I don’t have to follow the passive activity loss rules, and I could offset my W-2 income without having to become a real estate professional or an active participant.

There are some huge benefits on the losses. But as for the expenses themselves, not markedly different, really. Renovations, you can fix up repairs, you have a safe harbor of $2500 per area. If I’m fixing something in the house, I can treat it as a deductible repair. Otherwise, if it’s a renovation, it might be added to your basis and depreciated over 27½ years again. You see that we’re coming back to a recurring theme.

Things are written off over their useful life, unless you cost seg, bonus, or if it’s a repair. It says renovations, your travel expenses, furniture. Those types of things are going to be deductible regardless, whether it’s Airbnb or just a regular old rental. It’s not going to matter. Your management fees are deductible. Any cost of the debt is going to be deductible. Your property taxes are going to be deductible. There are lots of stuff.

Somebody says, “What does materially participating in an Airbnb means?” There are seven tests for material participation, three of them that are relevant. The first test is if you’re filing a joint return, it’s the husband and wife or spouses that could meet this test together. Otherwise, if it’s single, you have to meet this test. You provide substantially all the activities, and nobody else provides his substantial services. You don’t have somebody managing the property for you. If you do everything regardless of how much time you spend, you automatically qualify.

These are all ‘or.’ You can meet one of these and you automatically qualify. Test number two is I spend with your spouse more than 100 hours a year on these activities or on your Airbnb activity, which you could group Airbnbs. Let’s just say that on Airbnb, I spend 100 hours and nobody else spends more than 100 hours. I have other people working on the property, I have a property manager, but I spend more time than anybody else. I spend more than 100 hours and I would qualify.

Or you and your spouse spend 500 hours and it doesn’t matter what anybody else does. If we combined spent 500 hours on managing that activity and materially participating, then we’re good to go. You have those different rules. That’s what it is.

Eliot: Just one more that we have from Maggie about whether or not she can still materially participate if she pays herself out every month in Airbnb. Yeah, you can do that. That’s fine. That doesn’t have any impact on the material participation.

Moving on to our next. “Is it beneficial to set up an LLC versus an S-corporation? And are you able to pay yourself a reasonable salary with an LLC?” Every time we see an LLC, we have to know, well, how is it taxed? Because it can be taxed in a lot of different ways. It can be disregarded, which just means it doesn’t have a tax return. It could be an S-corp, it could be—

Toby: I was being cheeky there, Eliot. I’m putting my hands over my eyes. There’s no such thing as an LLC to the IRS.

Eliot: Exactly.

Toby: They’re going to ask you what it is for tax purposes.

Eliot: Yeah, we got to pick that tax treatment for it. There are rules behind that. If you don’t choose a tax status forth, the IRS will choose for you the basics. If it’s just one member, one owner, then it’s going to be disregarded. It means no tax return, it just goes on your 1040. If it’s more than one, then it’s going to be a partnership where you need a return, but it certainly can be taxed as an S-corp.

If we’re asking, what’s the difference between an LLC taxed an S-corp, in a regular S-corp, really nothing. Arguably, in many books of states, they’ll say that it takes less effort if you will to run an LLC. Most of those things would require a corporation. You’re going to want in your LLC anyway.

More meetings, you’re going to want to document your meetings. You want to have meetings to show that you’re running as a real business. Really no difference in that regard, unless you want to talk disregarded versus S-corp election. Any thoughts on that, Toby?

Toby: When it says, is it beneficial to set up an LLC versus an S-corp, again, like Eliot said, it depends on how the LLC is taxed. It’s bad for you if it’s setting up an LLC that’s disregarded and treated as a sole proprietorship. It’s almost identical if you set up an LLC and treat it as an S-corp for tax purposes. The only thing you lose by setting up an LLC instead of an S-corp proper is you can’t take 1244 stock loss as ordinary loss when it’s an LLC, versus if it was set up as an ordinary S-corp.

Can you pay yourself a reasonable salary from an LLC? It depends on how it’s taxed. If it’s an S-corp or a C-corp for tax purposes, it can pay you a salary. If it’s disregarded and it’s a sole proprietorship, then no, it cannot pay you a salary. If you are a partner in a partnership, it cannot pay you a salary. I hope you’re seeing that the LLC is not what matters. It’s how it’s taxed that actually matters.

Eliot: All right. “How should I hold my stock positions? What is the best way to deal with high capital gain consequences?” We often talk about setting up a trading partnership, that might be one option. If you set up a partnership between yourself as an individual and a C-corporation, then put the trading account into that partnership, you’ll be able to automatically deflect some of your earnings off your 1040 into the C-corp because it’s a partial owner of that partnership.

The C-corporation offers a lot in the way of reimbursements and deductions, so you get that money back tax-free. In other words, if you have 90% is owned by you personally, 10% by the C-corp, and maybe make $100, $10 is automatically going to be earned by the C-corp, $10 that would have otherwise gone on to your 1040 to be taxed.

Once it’s in the C-corp, we have a lot of reimbursements, deductions, and get that $10 back to you, tax-free. Whether a deduction at the same time to the C-corp so it breaks even, you get tax-free money. That’s one way of holding your positions in that trading partnership. Anything on that, Toby?

Toby: I would say that if they’re talking about what vehicle to hold it in, then there’s nothing better than a Roth IRA or a Roth 401(k) because you don’t pay any tax ever if you meet the requirements, however long you hold it and how old you are.

If you’re trying to get deductions against your capital gains or if you have other capital losses like, hey, I have all this capital gain that I’m generating now, but you have a loss carry forward from the last recession and you want to use that up, then you’d want to hold that individually or something that flows through to your individual return like a partnership.

If you have lots of deductions that you need, if you have expenses, you’re going to conferences, you’re an active trader, then what Eliot just said is gold, which is you would hold it in a partnership with a corporation as a partner in it so that it can write-off your expenses because you’re not going to be able to.

Since the Tax Cut and Jobs Act came out, they got rid of miscellaneous itemized deductions. If you pay a management fee, you can’t write that off on a stock portfolio. If you’re a super active trader, if you are doing more than 750 trades a year, more than 70% of the trade days you trade and you’re investing a substantial amount of your net worth, then you might qualify as a trader, in which case then you could be an LLC or you could just own it individually. There’s no asset protection if you do, but you’re able to write-off your business expenses, at least.

You can’t write-off the losses, their capital losses, so you need other capital gain. But if you’re a trader, you could do something called a mark-to-market election, and then you get ordinary business losses on it. But again, that’s not a reason to do mark-to-market elections. There are lots of people getting killed with mark-to-market elections at the end of the year when they have all these positions treated as they’re closed out and they have a taxable event, even though they never got rid of the underlying security. You only have to do that once before you realize it’s not a good idea.

Eliot: All right. Just a reminder, our tax and asset protection workshop is coming up on February 11th. Do you want to talk a little bit about that?

Toby: You can watch Clint. I’m sitting in the passenger seat on that. He does a really good job in the morning going over land trusts, LLCs, and corporations. In the afternoon, I go over taxation and legacy planning. It’s absolutely free. You guys can join it and spend a day with us. You won’t be disappointed.

I’ve never had anybody say that was a waste of my time. They usually say, dang, I did not know. By all means, pop on and give us a whirl. We do them live, we don’t record them, so you’re not going to get to see a recording later. The reason we do that is because we want to actually have you interact. Right now, we have Dutch, Patti, Troy. There are a whole bunch of folks answering questions in the back office.

I’m probably missing people. Dana’s probably there, too. Jared’s on there, I know there are a bunch of people. Matthew, there’s Tanya, there are a bunch of people, and Ander’s on there, as well as you and I. They’re answering questions in the Q&A.

What we want is that interaction. We want you to not only be learning, but to ask questions. We do that live. But if you come to spend some time with us, there’s usually a really special offer. We try to make it worth your while. You’re going to learn a lot about the way entity structures work and we’re going to give you a path forward.

Eliot: All right. Next question, “My husband will work as a real estate agent to qualify for the IRS definition of real estate professional and potentially use the passive losses from our rental property to offset my W-2 income on our joint tax return. The IRS rules say that my husband has to own at least 5% interest in the real estate, a company employing him. Does he need to form an S-corp as a contractor with a brokerage firm so that he owns at least 5% interest? Thanks.”

Yes, that’s exactly right. You’re going to want to have his earnings, if you will, from there being paid through an S-corporation that he owns, theoretically 100%, hopefully. In that way, you can take advantage of at least some of his hours towards the 750 hours now. Also, there are going to be tax benefits being in the S-corporation, but I know you’re going towards the real estate professional in your question here. But yes, that would be the first step in setting up that S-corporation.

I know we’ve talked a lot about this, Toby, amongst our advisors and things like that. The requirements, we want to have maybe an employee contract on that S-corporation. We want to be able to make sure that the broker knows how to send it to the S-corporation and items like that to check off. Any thoughts on that?

Toby: I always forget the name of the case, it starts with an F, that they use as the basis if you want to have the S-corp precede the money. The calling of this question, I don’t think you really have to worry. It sounds like they’re a real estate agent, which means they’re 1099 anyway. You don’t have to worry about the 5%. It’s if you own a brokerage or not own a brokerage, but you work for a brokerage.

Let’s say that you are an employee of a real estate brokerage firm. You can’t use that time towards real estate professional status if you’re just an employee. If you’re an employee with at least 5% interest, then you can. If you’re the receptionist, at a real estate office, you’re not going to qualify as a real estate professional because you’re not doing that activity, you’re not doing the buying and selling.

There are all sorts of stuff, management companies, construction companies, development companies. If you just work for a development company, it doesn’t make you a real estate professional. They want to see what time you’re spending. If you own a piece of the company, then they’re just going to assume that you’re involved. Otherwise, I have to do 750 hours and it has to be more than half my time. If you’re filing a joint return, either spouse can qualify.

In this case, my husband will work as a real estate agent to qualify. That means the husband just has to spend more than half of his professional service time, his work time, being a real estate agent and at least 750 hours. If he does that, prong number one of real estate professional status is met. All this means is that your passive losses become ordinary.

Prong number two, though, is you have to materially participate. You get that, you have to have material participation on your real estate. Prong number two is, do you meet one of those tests—I laid them out a little bit earlier, three of them—on your rental real estate? It’s each property, unless you choose to treat all your properties as one.

If you’re looking for guidance on this, it’s 26 USC 469(c)(7). That’s where you go to look for the passive activity loss rules. There’s a revenue ruling or revenue procedure, we call them a rev proc, on this precise issue that says, aha, you actually have to participate in your rentals. You do that.

Let’s just say husband sounds like he’s going to qualify. You don’t have to be an S-corp. You don’t have to do anything special. Just by the virtue of that, he’s a real estate agent, and they’re paying him 1099, he is the business, so we don’t have to worry about anything else. That’s prong number one.

Prong number two is, what about your rental properties? Are you guys managing them? Do you have somebody else managing them? Are you spending time on those as a couple? Do you qualify for material participation? If the answer is yes, then you can offset all of your income with real estate losses from those activities. And it gets even better.

All of your rental activities are treated as one activity, so you could go do a syndication. Let’s say you have a couple of single family residences that you pass the material participation tests because you’re managing them all yourself, you’re meeting all the time requirements, and you do a syndication. The syndicator, there’s nobody spending more than 100 hours on those properties managing them in a year, so you pass the material participation test.

You add up all those activities together, and you get this big, fat loss from the syndication. You get to use that to offset your real estate agent income and your other W-2 income. We could wipe out your income completely under that circumstance. You’d be walking away whistling Dixie pretty happy. You’re not going to have much of a tax liability at all if you meet those requirements.

Eliot: Lots of opportunity on this one.

Toby: That’s why it’s never a bad idea to have a spouse who’s a real estate professional. They don’t even have to work on your property. They could be in construction. As long as they’re in construction, they meet that test. You’re the one handling all of your other properties and you meet the material participation rule.

Let’s say you are managing five properties, that’s great. You don’t ever have to lift a hammer on those properties as long as you meet material participation and you’re married to a real estate professional—somebody in development, redevelopment, leasing, management, whatever, real estate agent, brokering—as long as you’re married to somebody, you’re going to meet that test and you could wipe out your income.

If spouse number one is a surgeon making $700,000 a year, they’re married to somebody who qualifies as a real estate professional, and you manage your own properties, you could unlock massive amounts of losses to offset a substantial chunk.

There are some limitations on how much loss you can take that’s around $500,000 a year. But let’s say you’re making 70,000, now all of a sudden, it’s down to $200,000, plus you get your standard deduction, plus if you contributed to any retirement plans. You can get that thing down to a really low percentage, if nothing else, because you decided to marry somebody who’s a real estate professional. Don’t real estate professionals look more attractive now?

Eliot: The dating sites are going crazy. All right. Next, “I sold an investment property in October 2021 and paid a very heavy capital gains tax. Can I get some of that back if I buy another investment property now?”

Toby: No.

Eliot: Yup. We missed the boat on that. We can’t carry back on any of these items at this point in the code. Maybe that’ll change in the future, but right now, we don’t have the ability to go back and change anything. Going forward, if you do have another investment property, perhaps you can take advantage of some of the things we talked about today to get some write-offs or some passive loss write-off if you’re not a real estate professional.

Toby: Lobby your congressman because what they did in the last recession was they allowed carrybacks for three years. They did it under the Cares Act and allowed carrybacks for three years. They did it with Obama when Obamacare passed for three years. That was how Trump eliminated taxes that he paid. They always talk about the $90 million loss that he carried back, that’s what they did. They said, oh, you can carry back.

There’s always the chance they change some laws and allow a carryback. But otherwise, no, you’re probably going to get hit with the capital gains tax. Unless you had capital loss that you didn’t properly account for, you could have done some things to offset it. Unfortunately, you would have had to have done those things within 180 days of the sale or the sale being assessed.

If that’s January 1st, you would have until about June 30th of 2022 to get an opportunity fund, and then you would have had to invest that before the end of the year. I think the boats sailed, but use it as a learning experience.

Eliot: All right. “How many years can you go without showing a profit?” I think, probably, where you’re asking this is coming from the hobby loss rules. That’s what we often talk about. If you have too much of a loss, the IRS could come in and say, hey, is this really a for-profit business venture that you have going on here? Really, what the hobby loss rule says is that if you’re profitable three of the last five years, then there’s a presumption that you are having a profit motive.

That doesn’t mean that you can’t rebut it if you have shown that. I’ve had clients who’ve had losses for several years. The IRS asked them about it. Hey, is this really a business? They just showed all the records and how they’re keeping it for their further business and things like that. The IRS says, hey, it’s tough getting started on business.

The IRS doesn’t like to enforce this one. They’re looking for the people who abuse. I bought a new camera and I want to show that it’s a business, even though I’m using it for all my personal use. That’s the thing that they’re going after. Any thoughts, Toby?

Toby: The provision is Section 183. I think it’s 26 USC 183. What’s interesting, as it says in the case of an individual partnership and I think S-corp, that if you make money three out of five years and then there’s another standard for horses for breeding, but if you make money three out of five years, you’re presumed to be in the business for a profit.

Let’s look at the one that they didn’t name, which was the C-corp. A C-corp isn’t affected by this rule, so you can lose money every year and you don’t have to worry about it. If you’re a partnership, a sole proprietor, or an S-corp, however, it’s a rebuttable presumption as Eliot said.

There’s a great case. I think the guy lost money for 18 years. It was the guy that wrote Midnight Train to Georgia. Does anybody remember that guy? Who wrote Midnight Train to Georgia? I’m going to ask the chat people. There’s always somebody who’s a music buff out there.

I believe it was him. What he did is he had his son go into the music business and lose money. I think it was 18 years in a row. He got audited and the IRS said that’s a hobby, but he showed that he operated in a businesslike manner, that he relied on the judgment of professionals, and that he expected to make a profit. He was able to overcome the presumption.

Somebody said Jim Weatherly. It was Gladys Knight & the Pips written by Jim Weatherly. Is it Jim Weatherly? I might be screwing up. I thought it was someone else. It might be. I’d have to go look it up. Does anybody remember that case? Let’s say it’s Jim Weatherly. Okay, maybe that’s who it was. I might just be completely butchering the case, but now I’m going to look it up and find out.

When you start talking again, if you see me on my phone, it’s because I have to go find that case now. I think it was 18 years that he lost money. They let him have his deductions. They said, you still had a profit motive, but he was just bad at business. Some people are just bad at business, but it doesn’t mean you don’t get your deduction.

What it really comes down to also, when you hear about the Hobby Loss Rule, it’s not that you lose the deduction, it’s just that you can’t take a loss. If you lose money, they’ll say, hey, you can only write-off up to your income. If you have no income and you just have expenses, we’re not going to let you keep writing that off.

If you had $100,000 of income and $150,000 of expenses, you’re just going to be at zero. They’re not going to let you have the $50,000 loss. Now I have to go look it up, so you go to another one. Now I’m going to research, but I never get to do this.

Eliot: I […] the next one like, Toby gets the right answer for us. “Is it okay to do your own taxes as a business owner if you’ve had a CPA for the last 20 years?” It’s certainly okay. You could have done that all in the last 20 years. If you’ve done your own returns, we wouldn’t recommend it. There are changes.

Let’s say we had this question back in 2018. We just had a massive overhaul of our tax code. You’re going to want a CPA, somebody who does taxes, EA, tax attorney, whoever it is, to walk you through some of those things. If anything changed in your personal world, even if the code didn’t, there are a lot of things out there. I wouldn’t recommend it.

Of course, we’re biased as tax people. I don’t think the wise money would be on doing it yourself, but you certainly are able to. Nobody’s going to fault you for that. I have her talk. I don’t know if it’s true or not. It might be an old wives tale that if they see returns prepared by a CPA firm, there’s less chance of audits. I don’t know if that holds any water or not, but it probably wouldn’t hurt. Again, directly to your question, you’re certainly welcome to do your own returns, but we just probably wouldn’t recommend it with all the complexity of the code.

Toby: I’m looking at this. I got to read this one now. This is killing me. There was a taxpayer that lost money for 42 years. They still prevailed. Primarily the motive for profit, it was Criley versus Commissioner.

That’s not the case I was looking for. It’s either […] or Criley, but that’s still crazy. Anyway, that was just case in point. I’m going to go find the other one and then we’ll have to talk about it next time, Eliot.

If you had a CPA for 40 years and your taxes are essentially the same year after year, I don’t know if I would cry if you did your own. Just know you got to sign them. And you have a CPA, you’re really using a CPA because you want to be able to say, hey, he said I could, to try to avoid some of the penalties.

It’s not what you pay for your return, it’s the value that you receive. Hopefully, your CPAs are doing more than just filing and hopefully they’re having a conversation with you in trying to lower that bill a little bit so that they’re paying for themselves. Anyway, I think you answered it right.

Eliot: “I bought a single family rental in November, still repairing it. No rent income yet, how to record depreciation costs for 2022?” We don’t have to worry about depreciation and any operational costs until you put it into service or at least it’s available for service, available for rent as we say. If we didn’t have it available for rent in 2022, there isn’t any deduction to take in those as far as operational, depreciation, or anything like that.

Maybe property taxes or something like that that you did incur, that’s not really operational, interest expense, perhaps. Typically, if it hasn’t been put into service, any repairs and all that, that’s all going to basis, in which case it will be depreciated that year that you finally do get it operational or available for rent.

Toby: Here’s the thing. If you have a property in LA, and I’m going to ask you this question because there’s somebody that just bought it. It never went into service and it wasn’t available, you don’t depreciate it yet.

Eliot: Correct, you do not.

Toby: If somebody bought it, and you made it available, and then you did a rehab on it after it was available, you just can’t create a loss from the vacancy. If we were talking to this person, they’re doing the single family, and they’re thinking, oh, I’m going to buy it and just got it, this is where you look and you say, maybe it’s worthwhile starting to renting it out for a month, even Airbnb-ing it for a little bit. Get it into service so that you’re starting that depreciation going on.

It really depends on whether you have other rental income. If you don’t have any other rental income, that’s probably not going to matter so much. There is a reason why you do it, start getting it kicked off, and get it into service, so you can at least start that clock running.

Eliot: Just make sure the repairs, there’s no big hole on the floor or something like that, if someone falls through and you got asset protection issues. If those repairs are minor and things like that, you can get that into gear and then get that depreciation in 2022. We couldn’t do that now. But looking back, anybody going forward, it’s a property, they can certainly take that tactic.

Toby: There are a bunch of good questions in chat. There are some that are bizarre that I’m not going to really read, but I do like them. There’s an IRA one and they’re talking about receiving gold. Here’s a hint. IRA rules are different from 401(k) when it comes to physical possession of gold. Do not take physical possession of gold in an IRA, but you can take physical possession of gold in a 401(k).

The rules are very, very different. One is treated as a distribution and subject to penalties and tax if you take the gold coins. Otherwise, make sure it’s a 401(k) because you don’t have that same rule for bullion and things like that.

Hey, there’s a YouTube channel again.

Eliot: Yes. I recommend that you subscribe to the YouTube channel. I’m sorry, who was the guitarist?

Toby: Joey DeMaio is there. I posted that already. If you guys like metal, you like Manowar, you like Metallica and hard rock, Joey used to actually tour with Black Sabbath. It goes back into the 80s. I think their band started in the 70s, technically. An old time rocker.

He’s over on a world tour right now. I think they’re going through Germany and Norway right now. They’re fun. He’s a kick in the pants. He’s just a really great musician, a great guy. Anyway, there are a whole bunch of podcasts in there. A lot of them are actually related to taxes, but I had to fanboy a little bit on Joey. Only the metal heads know who that is.

Eliot: “How to save on taxes by flipping and renting houses?” There are a lot of different things going on here. But if we can put a C-corporation into the mix, that is if you’re flipping you could flip directly through a C-corporation or at least an LLC disregarded to the C-corp, you get some good deductions and reimbursements that, again, you can’t normally do if you didn’t have that C-corporation. That might be good, or even an S-corporation for the flipping aspect.

If you have renting, you could still use a C- or an S-corporation. We’re going to recommend a C probably as a management company so you can do all your activities that you’re overseeing of your rentals through a C-corporation. It earns a management fee that shifts rental income off your personal return and puts it in that C-corp. Again, we use things like an accountable plan, maybe a medical reimbursement plan, corporate meetings under 280A. It gets some of that money back to you tax-free and saves some money there.

Toby: Yes. If you’re renting houses by flipping and renting houses, I don’t know what that really means, actually. I guess flipping is a dealer activity, it’s a trade or business. It does not qualify for 1031 or installment sales under Section 453. Flipping is its own little beast.

Renting houses can also be its own little beast. Saving taxes on renting houses is because you can depreciate them. Depreciation has nothing to do with cash flow, so you can end up with losses even though you have money coming in.

I’ll put it this way. Let’s say that you were talking to Congress. You got up there and you said, hey, what should I invest in? You say, I got the equities markets, I got this wonderful stock market I could invest in. Congress would say, yeah, that’s pretty good. We’re going to give you long-term capital gain treatment when you sell it, and we’re going to give you long-term capital gain treatment on the dividends that get paid out by those companies. We’re really going to take care of you.

You say, well, what about the investment? Can I write it off? When I invest in Coca-Cola, can I write it off? The Congress says, no, we’re not going to go that far. Now you go to real estate and they say, oh, we’re going to let you get long-term capital gain treatment. You can even avoid gain entirely—we’re going to make this thing called 1031—so you can buy more real estate. You can sell it and you can buy more real estate, you don’t even have to pay taxes.

You can defer the taxes. Then when you die, we’re going to let it step up. Your heirs don’t have to pay any taxes. You can do installment sales if you sell it and you want to recognize the income over 30 years. You could do that, too. We’re going to give you a whole bunch of goodies. Then you say, but Congress, will you do something for me when I buy it? How do I write it off?

They go, you know what? Unlike the stock market, we’re going to give you a deduction when you buy it. We’re going to let you start writing off the improvement value. You could just start taking that as a big old deduction. In fact, you can accelerate that. We’re going to let you write-off anything that’s a 5-, 7-, 15-year property right away. In 2023, it’s 80%. Last year was 100%. But they’re going to let you do this bonus depreciation, they’re going to let you take a big deduction.

You say, but what if I financed that property? What if I only put $100,000 down? Are you telling me I could get a $300,000 deduction on a million dollar house? Yeah, sure. For you, yeah, we’ll let you do that. Really? Yes. Congress is telling you what to do. Congress is saying, hey, we’re going to treat different types of investments completely differently.

What if I flip houses? What do I get for that? We’re going to beat you with a stick. We’re going to make you pay ordinary tax and self-employment tax. What if I sell it on a contract? You can’t do that. We’re going to make you pay tax even though you don’t get the money. You’re going to get it over 30 years, we’re going to make you pay tax on it as though you got paid everything on day one.

Congress hates flipping. Congress is telling you to buy rental properties. That’s what the tax code does. That’s Congress.

Eliot: That’s a big point on the flipping. We run into that every now and then. A client tries to sell it on an installment sale, and they don’t know anything about the tax code. If you sold it for $100,000 gain, you’re going to have to recognize all that gain in year one. Like Toby said, you’re not getting paid for 30 years on an installment. That doesn’t work well with flipping, so you have to be really careful out there.

Toby: Here’s a fun one. I just had a comment in chat. Janice said, “Hey, Toby, you said in the IRA, I can’t take physical possession of gold.” You can’t. They said, “But I got physical gold that will be kept in an IRS-approved Brinks vault.” Okay. You can’t have possession of the vault, Janice. It’s going to be someplace else.

There’s actually a really bad case that occurred where people thought they were buying physical possession of gold and the institution said that we have possession of your gold. Of course, there was no gold. The SEC came in and found out that it was all a scheme. They were selling people gold that didn’t actually exist. That’s why I can actually physically possess it and put it in my safe in my home.

Anyway, not to do a correction there, Janice, but there is a distinction between you being able to take physical possession versus having an approved third party. I believe the IRS wants it to be held in a bank vault. I’d have to go look at that, but there is a difference.

I just love it when people are actually digging into these things. It’s fun to have that conversation. I know it’s not talking about flipping and renting houses, Eliot.

Eliot: No, that’s a good one.

Toby: I’m like a cat, I get distracted easily.

Eliot: All right. “I just started my business in August of 2022. I would like to understand, from a tax perspective, what should be on top of my mind as we prepare to do the first return?” Hopefully, we had a really good record keeping of all the expenditures that you had. We’re going to want that because we’re going to need to break them up, what are expenses.

It depends on your business, I guess what it is, but you’re going to want to categorize those and have an idea of what the main groupings of the expenses are so you have some idea whether it’s a net profit or net loss, things that you could still do depending on the nature of the business, how it’s taxed.

In other words, if you’re a sole proprietor, you might still be able to contribute to a retirement plan if we had net gain there, or maybe a SEP IRA or something like that, perhaps, still at this point. I would look for things like that and make sure you have a good organization of your expenses and income so that someone can look at it right away and know if you have profit loss, and then look at it whether maybe you might be able to contribute to some plans or something like that.

Toby: If you started a business, too, I’d say just get familiar with ordinary, necessary business expenses. Meals last year, 100% deductible. All your equipment, like your computers and things like a cell phone for business use, you could write-off. If it’s a sole proprietorship, you have to divide it up between its business use and personal use. It’s a lot easier.

When you’re an S-corp, you can always write-off your startup expenses. If you set up an organization like an LLC, an S-corp, or a C-corp, you want to grab those organizational expenses and all your startup expenses that you incurred setting up the business. You’re going to want to grab those things.

You’re going to want to look for anything that helps you create a profit. There are so many things. Your automobile, you could probably be reimbursing yourself mileage. Depending on the type of business, things like your health coverage can be covered, or deductible. Your medical, your dental, again, it depends on the type of organization as to whether they’re deductible or not.

All those things, you want to make them front of mind and start saying, what am I spending, that helps my business? Personally, I think everybody that’s starting up a business should really be considering an S-corp because you get an accountable plan. I can avoid a whole bunch of the self-employment tax. I avoid having to do this weird home office filing that you do with a Schedule C on a 1040. You get away from that. I can just start reimbursing expenses, I don’t have to report.

I can write-off 100% of my cell phone, my data, and the actual equipment. I don’t have to sit here and play. What percentage of it did I use for personal versus business? It’s just so much better. The audit rate drops about 800%–1600%. You actually win your audits as opposed to sole proprietors losing about 94%–95% of their audits.

It’s in publication 55, table 17B. The last year they published that date, I think it was 2021. You can go look at it if you don’t agree. You’re like, no way. You actually go look at the audit rate, the success rate, and the change rate on it. It’s ridiculous if you’re a sole proprietor. It’s really, really, really bad.

I tend to look at those things whenever you’re starting up a business. Keep in mind the type of business and whether you’re going to sell it. If you’re doing a business that you anticipate having a lot of value in the next five or six years, the way you set it up could dictate whether you have tax when you exit.

There’s something called a 1202 small business stock where I could make $10 million, zero tax. I can make $20 million, zero tax. It just depends on how you set it up and what your exit is. I can’t do that with an S-corp and I can’t do that with an LLC. You start looking at these things, it lays it out and says what is your intention with the business, and am I getting the maximum amount of deductions that I want out of that?

Lastly, look at it from a business standpoint. If you’re going to be using leverage at all in that business, it’s a different animal. Now, I might not want to take all the deductions that I’m entitled to, or I may want to spread them out over a longer period of time because I may need to show income if I’m trying to get lines of credits and things like that, or if I need credit cards.

If I need to build the credit of that business, it’s a different animal entirely when I need to show earnings versus if it’s privately held and I don’t care. I’m not looking for loans and things like that. I don’t care. I just want to pay the least amount in tax. That’s a completely different animal.

Eliot: All right. I think this is our last one. “If an investor purchases a property that is lower in value than the property sold in the 1031 exchange, will the IRS disqualify the exchange entirely?” No. What’s going to happen is you just may not have full deferment of the capital gains, but they’re not going to disqualify it on that premise.

Sometimes people put extra cash into a boot that helps change how much tax might have to be paid, but you’re just really just putting more into the deal, more cash, as opposed to paying tax on it. It will not disqualify the exchange.

Toby: The additional amount. If you buy a property that’s less, you’re going to end up with cash and they’re going to call it boot. It’s a technical term, but it sounds cool. Hey, Eliot, you end up with some boot.

Eliot: I’m not going to touch that one.

Toby: Right. You end up with some income that you’re going to have to pay tax on, so that’s going to be disqualified from the exchange. I think they allocate it between recapture and gain, they’re just going to lower the amount. I can’t remember exactly, but it’s taxable. That’s what you got to know. It’s not going to be part of the exchange. I think they’re using it proportionality to your basis, to your recapture, and to the gain. Am I saying that right?

Eliot: Yeah. I would say yes, but it’s not going to disqualify it.

Toby: Yup, you’re correct. It does not disqualify. You just have a little bit of boot. If you mess around, like, hey, I financed the purchased property and ended up with cash, it’s called cash boot. Hey, I bought a property with the same value, but I did the financing. Wait until you close to do the financing. Otherwise, you’re going to have to have a taxable event. You just always have to be looking at those things.

Eliot: Don’t do the refinancing right before or right after. Give it a little time, either way, […] that.

Toby: Here’s the easy advice, work with a qualified intermediary. That’s what they’re there for. You can’t take possession of the money. You’re going to have to have one anyway, so get a good QI and ask them, hey, what can I do? And make sure that you’re following their guidance.

Eliot: All right. Just as a reminder, if you’ve got questions, please, you can email us at taxtuesday@andersonadvisors.com or visit us andersonadvisors.com and put your questions in that way. We’ll have another round of questions in two weeks for you. I think that’s pretty much all we have.

Toby: Let me say this so you can stop sharing. Actually, you keep that up there for a second. You can send in your questions. There are about 58 open questions right now that we’ve answered over 220 written questions plus everything that was in the chat.

If you have a question pending, you could stay on and wait for an answer. Otherwise, what I would do is I would submit it via the taxtuesday@andersonadvisors.com. Or if you’re a client, go into the platinum portal and post it. If you’re willing to wait around a little bit, these guys will keep knocking these things out. I think we should end the video in that portion of the webinar and then we’ll get to knocking out questions, so I’ll stay on and answer questions.

Eliot, if you could help these guys out a little bit, too. I do want to say thank you to Dutch, to Jared, Troy, and Dana. These guys are all tax professionals that are answering questions. Tanya, Matthew, Patti, and even Ander out there. They’re answering questions throughout this.

We’re doing it as a courtesy. They’re doing the very best they can to get answers today. I think we got crushed. We just had a lot of people on today. We had quite a few. We’ll get your questions answered. You have to stick with us. If you’re willing to wait a little bit, we’ll get to yours.

If you put it in Q&A and stop putting in more Q&As, we’re going to get this, but we want to be out of here before midnight. We’ll get that. Eliot, thanks for being on, brother. I really appreciate you coming in and reading all the questions and being there in the studio while I gallivant around the country.

It’s always a pleasure having you on, and you do answer your questions well. Thanks to everybody who asks questions. There are more questions coming in on the chat, even. Guys, stop that. Let’s get that in the Q&A, We’ll make sure that we get your answers no matter what. Even if you get off the event, we’ll look you up and we’ll find out who had a question that didn’t get a response to. We’ll make sure we get you something.

Until next time. We’ve got two weeks until we do another Tax Tuesday. Ask your questions via Tax Tuesday, Eliot has been running in and grabbing the questions. He’s been doing that. Thank you, Eliot, for doing that. That’s always been something I’ve done for years, and I like not having to do it.

Join us for the Tax and AP event. I think it’s February 11th, so it’ll be before the next Tax Tuesday. Hopefully, you continue to increase your knowledge and you can be a lethal tax planner, and save some of the hard-earned money that we all work so hard to create investments and to get returns. I think you need to keep a little bit more of it. Taxes are one of the ways to make sure that that happens. Eliot, unless there’s anything else.

Eliot: Thanks for joining us. See you in two weeks.

Toby: See you, guys.